Question

Life Insurance Need Analysis Case

Your friend John asks you for advice concerning life insurance. John, an auto mechanic, is 38 years old and currently earns $76,000 per year. John is married and has three children, Billy, age 5. Cindy, age 9, and Sally, age 13. John’s wife, Mary, is currently a stay at home mom. When Billy is old enough to attend school, Mary hopes to get a job as an administrative assistant in the children’s school. That position pays about $20,000 per year. Mary has a high school diploma and a certificate showing she completed one year of practical secretarial training. Mary is 36 years old. John and Mary pay $875 per month for their home mortgage, which will be paid off in 20 years. The interest rate on their mortgage is 5.3%. (Their current equity in the home is $28,000.) The couple owns two cars, one is 10 years old and in relatively good condition. The other is new, and their car loan payments are $450 per month for the next 42 months. The interest rate on the car loan is 4%. The couple’s personal property (such as clothes, electronics, furniture, etc.) is valued at $42,000. Their investments include checking, savings, and mutual fund accounts equal to $5,600. John has no life insurance. Mary has a $25,000 whole life insurance policy that was given to her by her parents when she turned 18. If John should die, Mary would receive approximately $3,000 per year for each child 18 years of age or younger from Social Security.

John and Mary spend almost all of John’s take-home pay each month. They are able to save $100 per month that they deposit into a tax-deferred college fund for the children. The college fund has been earning a respectable rate of return of approximately 6.7% per year.   The fund balance right now is $10,000. Their other investments earn approximately 5% per year.

John is worried about what may happen to his family is he should die. He is considering the purchase of life insurance and asks your advice. Assuming neither John nor Mary will receive large inheritances, how much life insurance do you think John needs on his life? (Use the needs approach.) Show all calculations and explain your answer. Make any assumptions you believe are reasonable, and make sure your assumptions are clearly stated. Also indicate the type of insurance you would recommend, whole life or term, and explain why.

Answer 1

Let us calculate the needs of the family:-

1) They consume the whole of John's annual income of $76000 this includes saving made for the college fund. Let us assume that the above consumption also includes the liabilities of home and a new car loan of $10500 and $5400 respectively.

2) Daily needs consumption for year = $76000 johns salary - $10500 for a home loan - $5400 for new car loan - $1200 for college fund = $58900

3) In case of John's death family will have no source of income except whole life policy of mary which will give her 9000 for first five years, 6000 for next 4 years and 3000 till 13th year. But family will have to continue to incur expenses for a home loan, car loan, college fund and daily needs. Assume that the expenses on daily needs will increase by 5% due to inflation.

4) let us assume that Marry will be able to work after 1 year when Billy turns 6 and is able to go to school. Also, assume that her salary will increase/hike at a rate of 5% per year.

5) She will continue to invest a similar amount $1200 annually till Billy (youngest child) turns 18 and ready for college. We will not go to complications of reducing the fund amount after Sally or Cindy turns 18 and go to college. The reason may be because of good returns getting on fund and the higher amount may be needed by Billy for college due to inflation. Also, there is a possibility of Sally or Cindy start working after they turn 18 or further go to college and then work, and contribute to the family income. We are ignoring this possibility at now.

6) Let us calculate each year Earning /Expenses

Year 1 = (-10500 for home loan) + (-5400 for car loan) + (9000 from insurance) + (-58900 for daily needs) + (-1200 for college fund) = -67000

Year 2 = -49945; year 3 = -52037 (calculations done in Excel, screenshot attached)

7) Now if we take term insurance , we will get one time payment now. So we will have calculate NPV of all years of Earning/ Expense. (Assuming 4% = r for NPV) ALso we will calculate NPV till year 20 which is home loan term.

NPV =, where En is Earning/Expense for year n

NPV = (-64423) + (-46177) + ...

NPV Total = -965279

8) if we take whole life policy, She will get fixed payment (not increasing according to inflation) for expenses. If she has to satisfy her expenses from this amount and her salary. The highest Earning/Expense should be equal to policy annual payment.

This amount is highest for Yr 20 = $111205

Final solution: If We are suggesting term plan then policy should be taken for approximate Sum assured amount of $965,279 and if we are taking Whole life plan then policy should be taken for the approx. Sum assured amount of $111,205.